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January 5, 2011

2011 Market Forecast (and a Review of 2010’s 4Q)

Growth is expected to lead markets higher in the first quarter

Investment returns were solidly positive in the fourth quarter. Increased consumer spending, a better-than-expected Christmas season for retailers, and improved earnings were the main catalysts for the rise in valuation.

Growth stocks led the market higher in the last three months of 2010, a trend we expect to continue for the next several quarters. Even after last year’s rally, there are still a number of attractive large cap stocks with dividend yields above those of 10-year Treasuries. We expect increased interest in these names, and believe that more than a few large technology companies will initiate dividend payouts owing to their large respective liquidity positions.

The fixed income sector did not enjoy the robust returns of equities. With the start of the third round of quantitative easing and the economy clearly on the mend, many market participants became concerned that interest rates (and inflation) may reappear. Although I think that such issues are more likely to occur at the end of 2011, it is clear that Treasury bonds are hardly an attractive option for most investment accounts. We believe that corporate debt and some areas of the mortgage market offer more opportunity.

Getting the Picture(s)

Investment Advisormagazine published my outlook for 2011 in its January issue. The article is intended to give clients a preview of what positions they may own in the coming year.

Unfortunately, all publications have page limits, and some graphics were not included. The following are three illustrations that I believe capture market realities in ways that words cannot.

Chart I. In the “lost decade,” stocks never had a chance against bonds. Source: Bloomberg

Chart I shows the return of stocks and bonds over the so-called “lost decade” of the 2000s. Fixed income investments, buoyed by lower interest rates and generally tighter credit spreads, dramatically outperformed equities in the period. In our view, this is not sustainable. We firmly believe that stocks will outrun their less risky rivals in the foreseeable future, as they did last year and in 2009.

Supporting the stocks-over-bonds mantra is our next chart, which shows that the correlation between the two asset classes is falling. As the article suggests, periods such as these are commonly associated with equity outperformance versus fixed income.

Chart II. The correlation between stocks and bonds is falling, which may indicate a change in market leadership between the two asset classes. Source: Bloomberg

Even though there is a strong likelihood that stock investments will dominate in the coming years, current concerns over sovereign debt problems, the health of states, and soaring budget deficits are likely to result in increased market volatility. Chart III shows the returns of managed futures during the worst months for U.S. stocks. We anticipate including such an investment in our portfolios in the second quarter, when a relatively low-cost mutual fund will be available to give clients this type of return dynamic.

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